The FED and the Bond Market

The Federal Reserve creates $85 billion a month in new money in order to subsidize mortgages ($40 billion) and U.S. government bonds ($45 billion). This is now considered normal. Any reduction in this increase is referred to as “tapering off.”

FED-watchers still expect the Federal Open Market Committee (FOMC) to announce a reduction to $75 billion at next week’s FOMC meeting. That would translate into $900 billion a year. Think about this. The expectation of $900 billion a year in newly created counterfeit money is regarded by the financial community as a return to conservative monetary policy. There has been fear that this will drop the stock market. It is a legitimate fear.

The problem is the bond market. How long can the FED create $900 billion a year without raising prices? Price inflation raises long-term bond rates. This drops the price of bonds.

But it does not drop the price of bonds held in the portfolios of America’s banks. As long as the banks do not sell these bonds, they are allowed to keep them at face value in the banks’ portfolios. This of course encourages banks to lend long-term to the U.S. Treasury.

The banks have bought these bonds at historically low interest rates. But until a bank sells the bond, it can keep the bonds on the books at play-pretend face value. This means that banks will not sell these bonds if rates rise. They will sit on them, the same way they are sitting on millions of homes with non-performing mortgages. They pretend that these mortgages are still performing. It is so much less embarrassing this way.

So, the subsidy to the U.S. government and the housing market will continue. The banking system will not sell bonds of houses they keep in the shadow inventory. The accounting laws encourage deception, so banks will continue to deceive.

This means that capital has been taken out of the job-creation sector of the economy, and has been permanently locked up. This is why the FOMC continues to inflate. It continues to deceive the public into believing that consumers are saving money. They are not. The FOMC is simply creating the illusion of thrift, of capital flowing into the economy to buy tools and launch projects. Americans are not saving much: maybe 2% of household income. The new money is then used to increase excess reserves at the banks. This holds down prices, but it also holds down investing.

Former banker Doug French describes what is going on.

Since the financial meltdown, banks haven’t been lending much. The collective loan-to-deposit ratio for the nation’s banks now hovers around 70 percent. Back in 2000, that ratio was 97 percent.

Instead of lending, banks are investing in long-term Treasuries.

It’s a subsidy to the federal government at the expense of private industry.

Bankers have also been padding their income by assuming all credit losses are behind them. Loan loss reserves fell by $6.4 billion to $149 billion in the second quarter. And that’s nothing new—banks have been robbing their reserves to boost earnings since the aftermath of the financial crisis. At the end of the first quarter of 2010, the industry had $263 billion in loan loss reserves. Simple math tells us this accounting trick has added $114 billion to banks’ bottom lines since 2010.

Big banks are also ramping up their exposure to derivatives, which were a catalyst for the financial meltdown. Investor Warren Buffett once called derivatives “financial weapons of mass destruction.” As of June 30, the banking industry’s derivatives exposure was $236.5 trillion. Ten short years ago that number was just $66.5 trillion. For the most part, this massive derivatives exposure does not appear on bank balance sheets. And while derivatives can diversify risk, they can also magnify risk in the same way leverage does.

This is the policy of the big banks, but they hold most of the deposits.

When asked what his biggest challenge was, Douglas Manditch, chairman and CEO of the $455 million asset Empire National Bank told American Banker, “I’m concerned about interest rates climbing in an unmanageable way. If things get out of control with inflation and increasing rates, it could be very difficult on a lot of community banks because there’s no way we can hide from that.”

Manditch went on to say the regulatory burden is “becoming impossible,” and is “never-ending.” Empire spends 16 percent of revenues just on compliance. A lot is now expected of bank board members, according to Manditch. “It’s to the point where you almost have to be a full-time banker to understand everything. It will be harder to get board members.”

So, the big bank bailouts have subsidized the U.S. government and the housing market. This has come at the expense of the job-creation sector: small local businesses.

Long-term rates will rise. The Federal Reserve is stuck with QE3. It dares not slow the flow of money into the bond market and the mortgage market. If it tapers, stocks will crater. But if it doesn’t, bonds will crater. Take your pick.

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